The Tough Choice Facing SAP's New Leaders: How to Cut Costs

As a rule, it's a good sign when a struggling company invests for the long term, emphasizing research and development over cost-cutting, and customers over Wall Street. SAP, the giant German software company that replaced its CEO in a management shakeup over the weekend, seems to be veering down that sensible path.

In SAP's case, however, a hard look at costs might be unavoidable. Expenses are way out of line compared to those of rivals such as Microsoft (MSFT) and Google (GOOG)SAP announced on Sunday that CEO Leo Apotheker, a company sales veteran who had been in the top spot for less than a year, was stepping down. He was replaced with two co-CEOs: Bill McDermott, who has been global field operations chief, and Jim Hagemann, former product development chief. Chief Technology Officer Vishal Sikka, who's based in Silicon Valley, was appointed to the company's executive board, a clear sign that R&D is gaining priority over sales as the company tries to overcome problems with declining revenue and profits. Sales fell 13.2% last year to $15.25 billion, according to Goldman Sachs. Net income fell 10.3% to $2.6 billion.

The stock has badly underperformed the market lately. It rose 14% last year, failing to keep pace with shares of rival Oracle (ORCL), which rose 34%.
Started Out Simply

Analysts were pleased with the shakeup and seem to have patience to endure a turnaround. "The new co-CEOs appointees are likely to focus more on margin leverage through top-line growth than through significant cost reductions from here, in our view," a team of Goldman Sachs analysts led by Sarah Friar said in a research note.

SAP, founded in 1972 by IBM (IBM) veterans, was created with large-scale customers in mind. The business model was simple: Sell big customers expensive proprietary business computer systems that are designed to sit on corporate servers and mainframes. But SAP has been slow to adapt to a world in which chief financial officers are pressuring their companies to hold down costs, cutting into SAP's margins and revenues.

SAP has also been late to embrace "cloud computing," in which customers lease software and computing power and storage over the Internet on an as-needed basis. It's trying to open mew markets among small and midsize businesses, but those efforts are also lagging. And it's tardy with mobile versions of its software, which is particularly shocking considering that Apple (AAPL) is one of its most important clients. If SAP had been doing a better job listening to its customers, it might have had a better handle on its market.

Apotheker made those problems worse by raising prices in the middle of a recession. No wonder software licensing revenue fell 28% in 2009.

Manage Its Way Through

The ideal solution would be a change of ownership, not a change of management. But that's unlikely to happen. "They should have sold to Microsoft, but it is too late for that," says Stephen Arnold, of Arnold IT, a tech consulting firm in Harrod's Creek, Ky. The founders, who still own large stakes in the company, are unlikely to sell at today's prices. Microsoft is already focused on mobile applications and smaller businesses.

Apart from pulling off some business-changing acquisition, the only realistic solution, then, is for SAP to manage its way through the turmoil as best it can. That won't be easy, because German business culture makes it difficult to cut costs. SAP has taken heat for eliminating 3,000 jobs, the largest downsizing in its history. IBM laid off more than 10,400 people last year, and it has been slashing jobs for decades. It cut 25,000 back in 1993. That's brutal for the people who are out of work, but IBM is now among the most profitable tech companies.

Given its headcount, SAP's revenue per employee is lower than that of many rivals. It has 47,500 workers and $15 billion in revenue. Microsoft has nearly four times as much revenue -- $58.5 billion -- but only about twice as many employees. Google has 20,000 workers, which is far fewer than SAP. But it generates $22 billion in revenue.

Both IBM and Oracle are similar to SAP when it comes to revenue per employee, but both generate more profits.
Cut Costs or Crank Up Sales

SAP is right to focus on product development and revenue growth. But its costs are out of line with those of its peers, and over time, that's unsustainable. It's going to have to cut those expenses or rev up its revenues enough to justify them.

Either way, the new management team must race to catch up with SAP's customers and rivals in a very tough environment.

Correction: An earlier version of this story underreported the number of lay-offs at IBM last year.